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The Daisy Chain Effect That I Anticipated Appears To Have Commenced!

Standard & Poor’s downgraded Spain’s long-term credit-rating to double-A with a negative outlook just one day after roiling global markets with downgrades for both Greece and Portugal.

“We now believe that the Spanish economy’s shift away from credit-fueled economic growth is likely to result in a more protracted period of sluggish activity than we previously assumed,” S&P credit analyst Marko Mrsnik said.

The move sent the euro to a fresh one-year low against the dollar of $1.3129; the 16-nation currency had briefly bounced higher as fears about Greek debt contagion eased. Spain’s IBEX index extended earlier losses, oil prices fell and U.S. stocks briefly turned negative.

This follows a downgrade of Portgual and Greece (to one of junk). The Actionable Intelligence Note of last week was quite timely. Up until a few days ago the options on many of these banks were quite cheap, on relative basis (even the Greek banks, at least on a relative basis though IV was high). Notice the explosion in both implied volatility and intrinsic value leading to a 100% to 200% gain...

For some odd reason, perceived risk is still nowhere hear where I believe it should be. Methinks the equity markets are still underestimating the risk attached to the Pan-European (at least thus far) Sovereign Debt Crisis.

The pressure on bank portfolios requisite risk to sovereign governments should not be underestimated, reference, How Greece Killed Its Own Banks! I will be posting what I see as explicit potential pathways for the contagion to develop, but in the meantime, I urge subscribers to review the following:

Non-subscribers should not attempt to read into the titles of subscription content. I believe that much of the whispering and pontification that I hear in the pop media is not necessarily very accurate. I have made my opinion of the entire debt debacle crystal clear, in explicit detail and in particular of the aforementioned countries, in the public domain. Please review:

9 comments

Completely agree with your well-stated points. I think that sovereign risk, coupled with the deterioration of housing and an inevitable double-dip in the States will lead to enhance the sufferings in the financial sector. With the Creditanstalt in 1931 it was a sudden withdrawal from US and British banks to further the chain reaction. May be a sudden jolt could occur based on sudden changes in the IRS market - interest rate swaps. Huge derivative exposures exist that pose significant danger of chain reactions in case of sudden changes in market fundamentals.

This is why more loans will not help Greece, and many of the other relatively unproductive countries. They need equity, not debt. More debt given to an overly indebted country can never lead to good things. Greece will get its equity either by defaulting or restructuring. It cannot print, thereby that quasi-equity machine is lost to them.

Several other countries have similar problems. The catalyst, if there is to be one, will be when the sovereign debt is devalued to the point where one bank has to call in a hedge or take a loss that was never economically there in the first place. Then I can see the daisy chain start to unfold.

Very good point, Reggie. When the inevitable finally happens (after the bailouts of the PIIGS, that ultimately will not work since this is not a liquidity crisis but a solvency issue), do you foresee the same counterparty problems we had with AIG, ultimately leading to further lowering of financial stocks, that by then will be hit by deterioration of balance sheet caused by bad mortgages? Thanks in advance.

I have a question for you. I give for granted long-term contagion from the PIIGS to Germany and France banking system, in light of heavy exposure - For example, check this http://online.wsj.com/article/SB10001424052748703798904575069712153415820.html#articleTabs%3Darticle
Do you have any idea on the risk of contagion from France-Germany to the US financial system? What is the exposure of US banks to Germany and France? I have checked this extensively, but have found no answers insofar.

Historically, the interconnectedness of the financial system across the Atlantic is documented by the failure of Creditanstalt in 1931, that ultimately exacerbated the 1929 market fall and led to the Great Depression.

You have a valid point, and I probably need to close that link. The static model (basically perpetual buy and hold) used to calculated the returns became much too unrealistic and unweildly as time progressed. Eventually, sales would have been made to either cut losses or lock in profits.

This is slightly off-topic. In the 'PERFORMANCE' section, the graphs are dated September 08. Is there a way to find what the performance of the portfolio would be as of today , starting from Fall 2007. I believe your research and I am going to subscribe again. My question is not meant to be rude. I was talking to someone that might be interested in a subscription, but I could not give an accurate number for the performance of Boombustblog model portfolio.

I fully understand that the market gets out of whack from fundamentals due to excess liquidity and other manipulation. So I am not trying to disparage your research in anyway.

Contrary to economic theory, monetary lags (the proxies for inflation & real-output) are not "long & variable". Money lags are of fixed length. This week's downdraft coincides with the end of these monetary flows. That's why the financial markets broke.

puts on PCY look interesting too given implied vol, a cheap and easy way for retail investors to invest in something similar to CDS. If I was into selling calls I would be doing that too, sitting near all time highs.